The Director of the SEC’s Division of Corporation Finance, William Hinman, recently delivered a speech outlining an analytical framework for the application of the United States securities laws to cryptocurrency transactions. More specifically, his speech suggests how the SEC staff will apply the long standing “investment contract” principles to token sales. This advisory summarizes the significant observations in his speech.
Bitcoin and Ether are Not Securities Today
Director Hinman acknowledged that the manner in which the virtual currencies Bitcoin and Ether are currently offered and sold do not involve securities transactions. Applying the investment contract test established in SEC v. Howey, he distinguished Bitcoin and Ether, which currently function on decentralized networks, from the tokens involved in many initial coin offerings (ICOs), whose values are dependent on the development efforts of sponsors. He observed that applying the disclosure regime of the securities laws to Bitcoin or Ether in their current state would add little value.
A Token Which Is a Security Today May Not Be a Security Tomorrow
The analysis of whether a digital asset is a security is not static. A digital asset is not inherently a security – it is simply code. It is the manner in which a token is sold and the reasonable expectation of its purchasers that are the determining factors in whether a sale is a securities transaction.
As a consequence, a token sale that is a securities transaction today may not constitute a securities transaction in the future if the network on which the token functions becomes sufficiently decentralized, so that any expectation of profit does not depend on the efforts of a third party. As a network becomes truly decentralized, purchasers of tokens no longer look to the managerial efforts of others and it becomes more difficult to identify an issuer or promoter to make the disclosures required by the securities laws.
Director Hinman outlined two sets of specific, non-exclusive factors to consider in evaluating whether a token is being offered as a security.
The first set of factors focus on whether a third party is driving the expectation of a return:
- Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value?
- Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?
- Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?
- Are purchasers “investing,” or seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?
- Does application of protections under the Securities Act of 1933 make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset?
- Do persons or entities other than the promoter exercise governance rights or meaningful influence?
The second set of factors focus on whether tokens are structured in a way so that they function more like a consumer item and less like a security:
- Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?
- Are independent actors setting the price or is the promoter supporting the secondary market for the asset or otherwise influencing trading?
- Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent?
- Are the tokens distributed in ways that meet users’ needs (e.g. can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use)? Are there built-in incentives that compel prompt use of tokens on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment?
- Is the asset marketed and distributed to potential users or the general public?
- Are the assets broadly dispersed or concentrated in the hands of a few that can exert influence over the application?
- Is the application fully functioning or in early stages of development?
While not an official statement of the SEC, Director Hinman’s speech provides useful guidance on how the SEC staff will analyze ICOs and other cryptocurrency transactions. Since most ICOs are undertaken by companies to fund their network development, it will be difficult for them to avoid the application of the securities laws under the principles outlined in the speech. A company considering an ICO should consult with experienced securities counsel at an early stage in its planning process.